Tom Zdon, Advent Software

Automation and the Alternative “RDR”: Managing Risk, Data and Reporting

Wed, 03/10/2012 - 06:15

By Tom Zdon (pictured), Vice President of Business Development and Solutions consulting, Advent Software Inc – With the worldwide market volatility of recent years, new regulation and increased investor due diligence, fund and global asset managers are under pressure to better manage risk, data and reporting.

From a regulatory perspective, FATCA (the Foreign Account Tax Compliance Act), Solvency II, the Dodd-Frank Act and EMIR (the European Market Infrastructure Regulation) have particularly stood out in recent months for their impact on how funds are managed and on reporting requirements.

From a company workflow standpoint, FATCA has or will impact most procedures and processes from the top down. This enterprise-level effort requires allocation of people, budget and project ownership across the businesses, operations, compliance and tax. It will most likely force firms to centralize their processes and systems across all of their divisions globally, which is not only a massive undertaking but leads to substantial organization costs and creates a heavy burden on resources.

The Solvency II regime for insurance companies will also require fund and asset managers to make drastic changes if they want to keep insurers as investors. Solvency II has a three pillar structure, requiring firms to disclose their capital and risk frameworks, but also to demonstrate how and where the requirements are embedded in their wider activities.

Pillar 1 sets out a valuation standard for liabilities to policyholders and the capital requirements firms will be required to meet—the Minimum Capital Requirements (MCR) and the Solvency Capital Requirements (SCR).

Pillar 2 deals with the qualitative aspects of a company’s internal controls, risk management process and the approach to supervisory review, including the Own Risk and Solvency Assessment (ORSA) which all firms will have to produce.

Finally, pillar 3 is concerned with enhancing disclosure requirements in order to increase market transparency, though the onus is on the firms themselves to interpret the requirements and to design the reporting. Most insurers will rely on fund and asset managers to provide the information needed to demonstrate acceptable risk levels.

Furthermore, the Dodd-Frank Act requires the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (“CFTC”) to gather information on investment managers’ private funds. In response, the SEC created Form PF for Registered Investment Advisers, setting the scene for more reporting. The first Form PF quarterly filing deadline was 29 August, 2012 for Registered Investment Advisors with regulatory assets under management over USD5 billion, while the majority of hedge funds face an initial filing deadline in 2013.

In terms of OTC derivatives, other regulations resulting from the same Dodd-Frank Act in the US and from the European Market Infrastructure Regulation (EMIR) effective this year fundamentally change the way these transactions are executed. While these regulations are expected to bring greater transparency to the market, they also present a number of operational challenges for fund managers. The new requirements significantly impact many aspects of how hedge funds and asset managers conduct business, including how they finance portfolios, manage collateral, and choose clearing houses and DCMs. 

These greater demands for transparency, disclosure and compliance mean that the investment management industry is increasingly requiring enhanced automation, integration, discipline and organization in many if not most of its workflows and processes, and the first thing firms need to ensure is the seamless delivery of third-party data into their systems, including custodial and market data, in a robust and reliable manner. Getting custodial data into a firm’s portfolio management system can be a complex process, entailing a myriad of manual and semi-automated steps to manage and manipulate custodial data to meet the requirements of the custodian’s business and software. Having the right IT integration in place can save time and greatly reduce the risk of error.

Similarly, with an appropriate market data integration solution, fund and asset managers can choose their market data source while streamlining the market data management process, thereby saving time and money. As a result, managers can collect, analyse, consolidate and distribute the data they need, when they need it, and meet reporting requirements.

To comply with FATCA specifically, from an IT standpoint, it’s critical that firms have a plan in place for technology enhancements or updates as they look to consolidate their process and procedures. Institutions will be required to change the way they support onboarding of new investors, capturing of accounting enhancements and changes, processing of new data as well as the ability to provide additional documentation that satisfies the new reporting requirements. Legal entities will require increased scrutiny and further analysis will be needed to determine the status of each entity under FATCA.

This particular area could be a major challenge because information about the various entities included within the expanded affiliated group may not be readily available, though it should become easier with the implementation of the Legal Entity Identifier (LEI). Also, transfer agency functions will be severely impacted as in some cases “KYC” (Know Your Client) information may not be readily available. For information that is readily available, accessing it will most likely require a major process change, as few organisations have a single, centralised source of client information to make required determinations with respect to accountholders.

With regards to Solvency II, overall the framework will require enhanced reporting from insurers in order to apply different capital charges to each, depending on their actual financial risk and risk concentration levels, encouraging diversification and active asset and liability management (ALM). This will likely lead those insurers to review their relationships and mandates with fund and asset managers. However, Solvency II will also require the use of mark-to-market valuations, thus introducing significant balance sheet and capital volatility. Insurers are looking for ways to manage this volatility appropriately, and that presents an opportunity for fund managers to offer their services in this capacity.

The specific proposals around asset-based capital charges will also have a major impact, as it could lead to significant changes in investment behaviour, prompting a move from equities to lower-risk investments like bonds in particular, but also putting in question any investment in funds that cannot provide “look-through” into their underlying assets. Indeed, under the new rules, assets, including collective investment funds and mutual funds, will be assessed on the basis of their underlying exposure to each of Solvency II’s market risk categories. Insurers holding investments for which this is not possible will be penalised by a heavy capital charge.

Some of the main data management and disclosure issues are:

  • The need for extremely granular asset data. In particular, providing accurate issuer and parent provider information. There are gaps in the information currently available, which managers, insurers and data vendors will have to work together to identify and fill in.
  • The need for industrial-strength look-through capabilities, including weightings of each underlying asset in a fund, to understand and manage the insurance firm’s overall exposure. To avoid heavy capital charges, insurers are likely to shun funds that cannot provide this level of look-through.
  • Quarterly frequency of reporting, required five weeks after quarter end, meaning insurance firms would need to receive all the data on assets almost instantly after quarter end to be able to produce reports on time. In the case of outsourced asset management, reporting will also need to be reviewed, including assistance for insurance companies to produce their ORSA.
  • The need for consistency in classification and naming conventions. The current Complementary Identification Code (CIC) standard may well take years to achieve this—some assets span several categories, and building a full convention will require following a very methodical and concerted process.
  • IT developments to ensure the required levels of granularity, speed and accuracy of reporting, along with enabled, full audit trails to certify that the proper controls and processes are in place.

To accurately complete Form PF, firms must not only gather significant amounts of data from multiple systems and make numerous calculations, but also aggregate specific data and transform it into an XML format for submission to FINRA, all within tight deadlines.  Without the proper software tools, this already complicated project could consume an enormous amount of time and effort.

To comply with OTC derivatives clearing regulation, under Dodd-Frank or EMIR, firms will need to perform what-if calculations that help ensure collateral requirements are managed effectively and that the optimal clearing house is used. They will also have to independently validate counterparties’ margin calculations, based on the calculation methodologies of each clearing house.

Finally, as fund managers increasingly need to demonstrate due diligence to their investors, they need to think about improving their control over their prime broker relationships. With a system that can provide automated cross-fund reporting, managers can achieve transparency across all portfolio charges and counterparty agreements, thereby reducing the risk of overcharging, ensuring accurate attribution of margin and financing charges, and reducing operational risk. They can also optimize the way they manage their investment research, with solutions that can help them organize, track, access and categorize the information they need to make investment decisions that deliver the most return for their investors and streamline their due diligence process.


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